Interest Rate Roundup

Friday, January 19, 2007

"good" asset inflation vs. "bad"

I really enjoyed reading this New York Times story about how so much money is going into commodity index funds that it's driving up the price of key foodstuffs -- hogs, grains, wheat, corn, you name it. Here's an excerpt:

"A recent study by the Commodity Futures Trading Commission, which oversees the nation’s futures markets, has found that Wall Street commodities index funds — investments in futures that track the underlying commodities of a particular index — have a much heavier concentration in agriculture futures markets than many had expected.

"The commission found the Wall Street funds control a fifth to a half of the futures contracts for commodities like corn, wheat and live cattle on Chicago, Kansas City and New York exchanges. On the Chicago exchanges, for example, the funds make up 47 percent of long-term contracts for live hog futures, 40 percent in wheat, 36 percent in live cattle and 21 percent in corn."

To which, I say with a bad pun fully intended: "You reap what you sow!" Bear with me while I explain ...

The Federal Reserve slashed interest rates and let money and credit growth run amok after the Nasdaq crash. Its strategy was to head off a serious recession. It worked. But then the Fed failed to "mop up" all the excess liquidity it created. So ever since then, we've seen a series of rolling asset/price bubbles as excess money chases return.

Residential housing is one clear example. So much investment money plowed into residential real estate that it drove house prices far out of reach of traditional buyers using traditional financing. Ironically, those price gains were deemed "good" asset inflation -- or at least, asset inflation the Fed would be willing to ignore. It had an easy excuse: Actual home price increases and decreases don't show up in the Consumer Price Index. The CPI measure of "housing" inflation is based on imputed rents, NOT the prices people pay for homes.

That bubble has clearly burst. But instead of draining away, liquidity has continued to surge and create asset price bubbles elsewhere. Commercial real estate prices are surging and property yields are plunging. Junk bond prices are jumping and yield spreads are collapsing. Heck, even obscure markets, like the mezzanine financing world, are being distorted by the excess of liquidity chasing returns (You can read more about that at this piece I just penned).

Once again, that's apparently considered "good" asset inflation. You certainly don't hear the Fed complaining about it the way it does about oil prices, wages, etc. Unfortunately, as this Times story shows, you can't keep excess liquidity down forever. Eventually, it spills over and creates "bad" inflation. That's what happened with crude oil and gasoline (clearly, some of the price gains stemmed from investment money buying up futures) ... and now, that's what is happening in another commodity market sector -- foodstuffs.

If we're ever going to stop these rolling asset bubbles, we're going to have to drain some excess liquidity from the system. It's as simple as that. The question is, will the Fed (and other global central banks, for that matter) do so?


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